S Corporation Stock Was Subject to Substantial Risk of Forfeiture Until Restrictions Lapsed

Transcription

1 S Corporation Stock Was Subject to Substantial Risk of Forfeiture Until Restrictions Lapsed Austin, TC Memo The Tax Court has concluded that stock held by two S corporation shareholders (each of whom held 47.5% of the stock) was subject to a substantial risk of forfeiture when issued to them and remained subject to that risk until the restrictions lapsed by its terms. Under Code Sec. 83(a) if property is transferred to a taxpayer in connection with the performance of services, the excess of the fair market value of the property over the amount, if any, paid for the property, is included in the taxpayer's gross income in the first tax year in which the taxpayer's rights in the property are transferable or are not subject to a substantial risk of forfeiture. The rights of a person in property are subject to a substantial risk of forfeiture if the person's rights to full enjoyment of the property are conditioned upon the future performance of substantial services by any individual (sometimes termed an earnout restriction). (Code Sec. 83(c)(1)) Property is not transferred subject to a substantial risk of forfeiture if at the time of transfer the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced. The regs provide the following five factors for determining whether the possibility of forfeiture is substantial in the case of rights in property transferred to an employee of a corporation who owns a significant amount of the stock of the employer corporation: (i) the employee's relationship to other shareholders and the extent of their control, potential control and possible loss of control of the corporation; (ii) the employee's position in the corporation and the extent to which he is subordinate to other employees; (iii) the employee's relationship to the officers and directors of the corporation; (iv) the person who must approve the employee's discharge; and (v) the employer's prior actions in enforcing the provisions of the restrictions. (Reg (c)(3)) For purposes of subchapter S, stock that is issued in connection with the performance of services and substantially nonvested is not treated as outstanding stock of the corporation, and the holder of such stock isn't treated as a shareholder solely by reason of holding it (unless the holder makes a Code Sec. 83(b) election to include an amount in gross income in the year of transfer). (Reg (b)(3)) As noted by the Tax Court, for the period at issue in this case, the S corporation provisions created a framework under which all the outstanding shares of an S corporation could be treated as owned by an ESOP, making the company's income immune from Federal income tax. The Court noted this arrangement was well known and frequently used by tax practitioners. In 2001, Congress amended the Code to attribute to certain non-esop shareholders of a closely held S 1

2 corporation any income allocated by it to an employee stock ownership plan (ESOP). (Economic Growth and Tax Relief Reconciliation Act (EGTRRA) sec. 656(d) (codified as Code Sec. 409(p)). However, this change was made prospective only and generally did not apply to plan years before 2005 for an ESOP (like the ESOP in these cases) that existed before Facts. In a Code Sec. 351 transaction in December of '98, Larry Austin and Arthur Kechijian (the taxpayers) each transferred his respective ownership interests in a group of related corporations and limited liability companies (the UMLIC entities), with a cost basis of $142,566, to a newly formed S corporation holding company called UMLIC Consolidated, Inc. (UMLIC S-Corp). In exchange, they each received 47,500 shares of UMLIC S-Corp's common stock. The taxpayers each executed a Restricted Stock Agreement (RSA) and an Employment Agreement with UMLIC S-Corp which required them to perform future services for UMLIC S-Corp in order to secure full rights in their stock. These agreements specified a 5-year earnout period and provided that either taxpayer would forfeit 50% of the value of his shares if he voluntarily terminated his employment with UMLIC S-Corp before Jan. 1, Consent from 100% of the holders of UMLIC S-Corp shareholders was required to remove or waive this restriction. In December of '98, UMLIC S-Corp funded an ESOP with a $500,000 loan, which was used to purchase 5,000 shares of its common stock. As of Dec. 18, '98, each taxpayer owned 47.5% of the company's common stock with the ESOP owning the remaining 5%. In August of '99, each taxpayer established an irrevocable grantor trust for the benefit of his family, with each transferring 24,500 shares of UMLIC S-Corp common stock (which was still subject to the RSA) to his trust in exchange for a $1.83 million promissory note. In late 2003, the taxpayers reorganized the ownership structure of their business. Under the plan, all of UMLIC-S Corp's assets, consisting principally of its operating subsidiaries, would be transferred to a new holding company wholly owned (directly or indirectly) by the taxpayers. The new holding company, which would thereafter conduct the same business, would be organized as an LLC, thus facilitating possible investment by private investors. UMLIC S-Corp would be left with cash equivalents, essentially freezing its value and the value of the 5% stake held by the ESOP as of the date the sale was consummated. In addition, the new holding company would acquire a stepped-up basis in the acquired assets for depreciation and amortization purposes. In October of 2003, taxpayers formed UMLIC Holdings LLC (Holdings), as the acquiring company, with each taxpayer (through intermediaries) holding a 50% membership interest. Because UMLIC S-Corp proposed to sell substantially all of 2

3 its assets to Holdings, the transaction had to be approved by the former's shareholders, including the ESOP. To avoid potential conflicts of interest, the taxpayers (who made up two of the ESOP's five trustees) resigned their roles as co-trustees. UMLIC S-Corp's controller was selected to serve as successor cotrustee with another senior employee; both were ESOP beneficiaries. In December of 2003, the taxpayers engaged in a series of transactions that caused UMLIC S-Corp to reincorporate in another state (renamed UMLIC Consolidated, Inc. (New UMLIC S-Corp)) and elect to be an S corporation. At that time all of the stock held by the taxpayers and their grantor trusts was converted to New UMLIC S-Corp stock. On Jan. 1, 2004, the restrictions on the taxpayers' stock (now New UMLIC S- Corp stock) lapsed. The fair market value of the 47,500 shares of stock held by each taxpayer and his grantor trust was $45,857,434. The taxpayers executed a series of transactions in order to avoid having to report this amount of their 2004 returns as compensation subject to income and employment tax. On Mar. 30, 2004, each taxpayer entered into a surrender agreement and a subscription agreement with New UMLIC S-Corp. These agreements provided that each taxpayer would surrender his 47,500 unrestricted shares and simultaneously repurchase 47,500 identical shares in exchange for a $41.5 million promissory note with a 10- year term. On June 30, 2004, New UMLIC S-Corp paid a distribution (the special dividend ) of $35 million. Each taxpayer received $8.47 million for his 23,000 shares. Each of their grantors trust received $9.03 million for their 24,500 shares. Parties positions. The taxpayers contended that their stock in UMLIC S-Corp was subject to a substantial risk of forfeiture when they received it in December of '98 and remained subject to a substantial risk of forfeiture until Jan. 1, 2004, when the 5-year earnout restriction lapsed. Because the 95,000 shares owned by the taxpayers and their grantor trusts were deemed to be non-outstanding, UMLIC S-Corp for tax years allocated 100% of its income, losses, deductions, and other tax items to the ESOP. Consistently with this reporting, neither taxpayer reported any flowthrough items from UMLIC S-Corp on their returns for 2000, 2001, 2002, or (And because the ESOP was a tax-exempt entity, it likewise reported no taxable income from UMLIC S-Corp for ) For 2004, each taxpayer took the position that he had surrendered his original shares and acquired replacement shares worth $46 million in exchange for a $41.5 million promissory note. Accordingly, each reported the difference between those amounts, or $4.5 million, as compensation income under Code Sec. 83. They contended that they and their grantor trusts had acquired an increase in basis in the New UMLIC S-Corp shares by virtue of the respective $41.5 million 3

4 promissory notes so that the $35 million special dividend merely reduced their respective bases and generated no additional taxable income to either. On the other hand, IRS contended that the taxpayers' stock was substantially vested when they received it in December of '98; that their stock was thus outstanding for subchapter S purposes throughout the tax years at issue; and that the taxpayers consequently had been required to report their pro rata shares of the company's income on their returns. IRS further determined that the taxpayers did not have sufficient bases in their New UMLIC S-Corp stock to make the 2004 special dividend nontaxable. Court's conclusion. The Tax Court concluded that the taxpayers' stock was subject to a substantial risk of forfeiture when issued to them in '98 and remained subject to that risk until the restrictions lapsed on Jan. 1, As a threshold matter, the Tax Court rejected IRS's contention: (1) that Code Sec. 83 was inapplicable because the taxpayers supplied only property and no substantial future services in exchange for the UMLIC S-Corp stock; and (2) that the taxpayers couldn't have received stock that was substantially nonvested for Code Sec. 83 purposes, and yet concurrently have owned at least 80% of the total combined voting power of all classes of UMLIC S-Corp stock as required for income nonrecognition under Code Sec. 351(a) and Code Sec. 368(c). The Court reasoned that the RSAs and the employment agreements by their terms required the taxpayers to perform substantial future services for UMLIC S-Corp to receive the full value of their stock. And Reg (b)(3) by its terms only applies for purposes of subchapter S and IRS cited no authority for the proposition that it would disable a stock-for-stock exchange. The Court found that the key question in this cases was whether if either of the taxpayers had quit his job before the end of the 5-year earnout period UMLIC S-Corp would likely have enforced the restriction requiring that he forfeit 50% of the value of his shares. Analyzing the factors under Reg (c)(3), the Court concluded that the answer to this question was yes. Given the complementary nature of the taxpayers' responsibilities and skill sets, it was in each taxpayer's economic interest to have the other remain with the company. To incentivize this, they executed reciprocal agreements under which each would lose 50% of the value of his stock if he left the company within five years; as the Court expressed it, they thus tied each other to the mast for a five year period. Further, if the departing taxpayer forfeited 50% of the value of his stock, the value of the remaining taxpayer's stock (and that of the ESOP) would be increased accordingly. Conceivably, both taxpayers might have decided independently that they wished to retire early instead of serving out their promised 5-year terms. However, the ESOP had a strong economic incentives to refuse such consent: (a) if the 4

5 taxpayers left the company, the company might well fold, and the ESOP beneficiaries would then lose their jobs; and (b) if the taxpayers forfeited 50% of the value of their stock, the value of the ESOP's stock would be increased astronomically. The Court dismissed IRS's argument that the taxpayers could control the other ESOP trustees to vote for consent or waiver, finding that IRS ignored the fiduciary duties that the trustees owed the ESOP. Further, the Court found that the taxpayers themselves wouldn't have acted as ESOP trustees for such a vote because approving the removal of the forfeiture provision affecting their shares would have been directly contrary to the economic interest of the ESOP and a grotesque conflict of interest for the taxpayers. The Court was confident that the taxpayers in such circumstances would have resigned as trustees, as they in fact did in 2003, rather than face the consequences of a self-dealing charge. The Tax Court also reject IRS's contentions (1) that the incorporation of UMLIC S-Corp as a holding company lacked a legitimate business purpose and was devised solely to avoid taxes; and (2) that the ESOP lacked economic substance because was a mere accommodation party that enabled the taxpayers to defer receipt of income from UMLIC S-Corp. The Court found that the taxpayers observed all corporate formalities in creating and operating the holding company structure, and it had economic substance apart from tax considerations. It also reasoned that although the UMLIC entities previously had a section 401(k) plan in place, the Code did not prevent the taxpayers from providing an additional incentive in an effort to retain existing employees through the ESOP, whose beneficiaries included all of the company's eligible employees. However, the Tax Court found that despite the simultaneous surrender and subscription agreements with New UMLIC S-Corp, Code Sec. 83(a)(1) required that the fair market value of stock be treated as compensation income to the shareholder at the first time the stock becomes substantially vested. That occurred on Jan. 1, 2004, and Code Sec. 83 requires a snapshot valuation as of that date. The value of the stock each owned on Jan. 1, 2004, directly or through his grantor trust, was $45,857,434. Each thus received taxable compensation in excess of $45 million at that time. No subsequent actions with respect to the stock, whether a sale to a third party or surrender to the corporation, could change that. Further, this $45,714,868 income inclusion under Code Sec. 83 provided a basis increase under Reg (b)(1) so that each taxpayer's basis in his New UMLIC S-Corp shares was increased by this amount. In any event, the Court determined that it was clear that the simultaneous surrender and repurchase transactions were palpably lacking in economic substance, motivated by no business purposes other than obtaining tax benefits. Neither taxpayer could envision a reasonable possibility of profit by surrendering, for no consideration, stock worth $45.8 million, and no rational person would incur indebtedness of $41.5 million to acquire stock that he already owned free 5

6 and clear. In addition, the notes themselves lacked economic substance since each taxpayer then owned a 50% interest in New UMLIC S-Corp, so each was in effect issuing, for no rational business purpose, a $41.5 million promissory note to himself. 6